Hunt for Brexit-Beating Trade Spotlights Inflation-Linked Debt

  • 10% drop in pound could increase inflation 0.75ppt: Carney
  • Bond market inflation outlook near highest since January

Implications of Brexit

Investors looking for a storm cellar if Britain votes to leave the European Union may find it in inflation-linked bonds.

U.K. government securities that pay more interest when retail prices rise are well-placed for a boost should Britain leave the world’s largest common market. Analysts say that breaking from its 27 commercial partners would send the pound tumbling, increasing the cost of imported goods. A bond-market gauge for the inflation outlook last week matched its highest level since January.

“Surging oil prices, the depreciation of the currency and the deterioration in the short-term outlook for the U.K. economy” will have a “boosting impact” on inflation in a Brexit scenario, said Sergio Capaldi, a fixed-income strategist at Intesa Sanpaolo SpA in Milan.

The prospect of a Brexit has drawn dire warnings from Chancellor of the Exchequer George Osborne to the International Monetary Fund about the harm it would have on U.K.’s economy. While that’s seen as bad news for the pound, it may encourage bondholders who believe the Bank of England won’t raise borrowing costs anytime soon. Also supporting linkers are bets that they will get an extra boost from the currency implication for inflation.

Carney’s Calculation

Looking at the effective exchange rate for the pound, which is trade-weighted to reflect the influence of imports and exports, BOE Governor Mark Carney said a 10 percent depreciation will likely increase annual consumer-price inflation by 0.75 percentage point in two to three years. Carney released calculations on Wednesday for what a slide in sterling could do to the economy in a so-called Brexit, in a response to a lawmaker’s request.

QuickTake Will Britain Leave the EU?

Still, in a letter, Carney again noted the BOE has not made a prediction for what may happen to the economy or in financial markets if Britain quits the 28-nation EU.

Capaldi said he expects the 10-year break-evens rate, a measure of inflation expectations derived from the yield difference between conventional 10-year gilts and those linked to retail prices, to increase to 3 percentage points from about 2.3 percentage points currently if Britain leaves the EU. “Linkers will likely outperform in that case, with nominal bonds suffering the most.”

The rate rose almost 0.2 percentage point in the past two months as Brexit concerns intensified in the run-up to the June 23 vote. It touched 2.41 percentage points, the highest level in about three months, on April 21. The five-year break-even rate climbed this month to its highest since July.

Comparing Returns

U.K. index-linked securities, which are fixed to retail rather than consumer prices, outperformed gilts in the six weeks after the referendum was announced. Their 1.5 percent return beat a 0.1 percent gain in conventional bonds in that period, according to Bank of America Merrill Lynch indexes. That advantage disappeared in the past week, as the pound rebounded amid speculation Brexit was less likely.

Britain’s currency has declined about 8 percent versus the dollar since a peak in June 2015. And though it went through a relief rally in the past two weeks, it’s still the developed world’s worst-performing major currency in 2016.

The crude-oil recovery is helping push inflation expectations higher. Oil prices stabilized in April, after slumping to the lowest level since 2003 in February.

A Brexit “should be positive for break-even rates over a longer term” also because the BOE should turn more dovish to cushion the possible negative effect of the country leaving the EU, according to Mohit Kumar, head of rates strategy at Credit Agricole SA’s corporate and investment-banking unit in London. “However, the short-term impact would be driven by risk aversion,” with foreign investors selling gilts and domestic ones buying into fixed income.

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